The Economic Growth and Tax Relief Reconciliation Act of 2001 is one of the most significant pieces of tax-cut legislation in more than two decades.  But for the individual who may die between 2001 and 2011, the Act is a nightmare to appropriately plan around.

The Repeal of Estate and Generation Skipping Taxes is a relief to many, however, there is a phase-out period between 2002 and 2009, and in 2011, if the Act is not revisited, then the tax rate and exemption return to the 2001 amounts.  To illustrate, the estate of a deceased individual with a $2,000,000.00 estate pays $675,000.00 in estate taxes in 2001, $225,000.00 in 2005, no estate tax in 2006, and $675,000.00 in 2011!

In addition, in 2010, when the estate tax is repealed, there will be no more step-up in basis as to inherited property.  This could have a significant impact on those estates holding highly appreciated assets, including the family farm and low basis stock.  The final draft of the Tax Act does have an adjustment to basis for certain inherited property (up to $1,300,000.00), but some property is not eligible for basis increase, such as stock in foreign investment companies.

The Gift Tax has not been repealed, but the exemption will increase to one million dollars in 2002 and is set to remain at this amount through the phase-out period.  The maximum gift tax rate will also decline, as estate tax rates will during the phase-out period.

In this time of uncertainty, it is wise to revisit any tax planning which was completed prior to the enactment of the new Tax Act.  To illustrate, if Mr. Rich Guy dies in 2010, having set up standard credit shelter trusts in his will prior to 2001, there may likely be a provision in the will, as follows:  "I devise to my Family Trust, (i) Any assets which, if passing outright to my wife, would not qualify for the marital deduction in the federal estate tax proceeding relating to my estate, and (ii) That fraction of my residuary estate the numerator of which shall be a sum equal to the largest amount, if any, that can pass under this subparagraph free of any federal estate tax in the federal estate tax proceeding relating to my estate..."  If there is no federal estate tax, then Mr. Rich Guy's entire estate passes to his Family Trust and bypasses his wife's estate or a trust set up for her benefit.  Certainly, this was not Mr. Rich Guy's intent when he created the credit shelter trusts in his will, and the consequences could be dire for the surviving spouse.  The problem lies in creating an estate plan which works in the year 2001, 2005, 2006 and in 2011.  Certainly, even planning for a full repeal, as in the case of a younger family, may have dire consequences if the estate tax is reinstated.

That being said, there are still some good tax planning devices which can be utilized to plan for the uncertainty.  One devise is the use of a disclaimer, where Mr. Rich Guy could leave everything to his spouse, and he would then have the right to disclaim any portion that would be taxable in her estate when she dies thereafter.  Formulas can be created in Family Trusts limiting the sums which would bypass the spouse's estate to fund the Family Trusts.  Certainly, life insurance becomes a valuable asset because the case received under the policy is tax free and will not need any basis adjustment.

To summarize, both those in favor and those against the full repeal of the estate tax believe that in 2011, we will likely have some sort of estate tax, but not the tax rate and exemption in place in 2001.  In this time of uncertainty, flexibility is the key, and after-death tax planning will certainly carry a premium.

For a complimentary review of your present estate plan, contact Laura Howell at (919) 250-2101, or e-mail her at lhowell@smithdebnamlaw.com.

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Bankruptcy
Chapter 11 Difficult but Valuable Medicine for Ailing Businesses

Every day the headlines indicate that employees are being laid off and businesses are failing.  The economic downturn is affecting all industries, especially manufacturing, telecommunications, dot-coms and healthcare.  Other sectors, including real estate and retail, are showing strain also.  This activity is reminiscent of the late 1980's and early 1990's when chapter 11 cases abounded.  Will ailing individuals and businesses again seek a dose of bitter, but often valuable medicine, the protection of a chapter 11 reorganization?

Chapter 11 filings are on the increase.  Chapter 11 of Title 11 of the Bankruptcy Code offers individuals and businesses an opportunity to deal with financial problems and develop a feasible plan for repaying their creditors.  Chapter 11 is available to individuals, partnerships and corporations.  A chapter 11 filing stops most creditor action while the plan is developed.  It is very important that chapter 11 debtors have good accounting assistance to prepare financial projections and develop a breakeven to positive cash flow quickly.  The court will not permit continued losses to the detriment of creditors who extend credit after the bankruptcy case is filed.

During the chapter 11 case, all payments to pre-bankruptcy unsecured creditors must cease and interest will not accrue on unsecured debt.  Payments to fully secured creditors and lessors must generally continue unless the collateral or leased property is "abandoned" back to the creditor.  If the debtor has burdensome real estate leases, chapter 11 offers a means to reject the leases and significantly limit the damages from rejection to rent reserved by the lease for the greater of one year or fifteen percent of the balance of the remainder of the lease, not to exceed three years.  Equipment leases and employment agreements that are burdensome can also be rejected, and the damages are treated as pre-petition unsecured debt.

In 1994, Congress amended the Bankruptcy Code to add some new laws that affect "single-asset" chapter 11 cases, such as hotel, office or an apartment building, which is the sole asset of a debtor.  Section 362(d)(3) provides that the automatic stay will be lifted to permit foreclosure by the secured lender in such case if the debtor does not commence monthly payments of interest at a current fair market rate or file a plan of reorganization that has a reasonable possibility of being approved by the court.  Typically, there are few unsecured creditors in such cases, and the law makes it less likely that the debtor can file and stymie its single large secured creditor without making payments or filing a plan promptly.

In most cases, the Bankruptcy Code allows the chapter 11 debtor a minimum of four months to make the changes necessary to improve profitability, stabilize the company and develop projections for a feasible continuation of the company and repayment of creditors.  Chapter 11 can also be used to wind down or liquidate a business or assets in an orderly fashion.  A "plan of reorganization" gives the company considerable flexibility in determining how to repay its secured and unsecured creditors.  With regard to secured creditors, acceleration of loans can be reversed, and the maturity of loans can be extended.  Assets can be sold or abandoned to secured creditors for a "credit" on the secured debt related to the fair value of the collateral.  Sometimes the interest rate can be modified.  If a creditor is "under secured," its loans can be treated as partially secured and partially unsecured.  This significant benefit would be impossible outside of the Bankruptcy arena.

Tax liabilities can be repaid over a six year period from the assessment of the taxes at the statutory rate of interest.  This treatment is provided for in the Bankruptcy Code and is not subject to approval by the tax authorities.  

With regard to unsecured creditors, there are very creative ways to treat this group.  Often unsecured creditors are provided notes for repayment of some portion of their claims over time, for example, five years.  The minimum amount which must be paid to unsecured creditors is the amount they would receive if the company filed chapter 7.  Often the amount paid would be zero.  Therefore, a feasible chapter 11 plan that offers payment of 25 to 50% on the dollar is often attractive to the "trade creditors" and they may readily accept it.  If a company cannot feasibly propose a fixed payment to its unsecured creditors, then it can propose that its creditors take stock in the company.  Typically, the stock that is given is preferred stock with voting rights.  When stock is given to the unsecured creditors, the debtor emerges from chapter 11 with a substantially improved balance sheet.  It is critical to obtain qualified bankruptcy counsel to assist in a chapter 11 case.  Such legal work is very specialized and requires knowledge of the bankruptcy laws,  the court and its required procedures.  Experience in dealing with creditors and their counsel is invaluable.  Often the services of an accountant and "turnaround" consultant are required as well.

Even through chapter 11 can be an expensive endeavor and should only be used when the business has enough "life" left to justify resuscitation, chapter 11 is a very valuable tool,--especially for businesses with the willpower to reorganize.

For more information, contact Hunter Wyche at (919) 250-2103 or by e-mail at hwyche@smithdebnamlaw.com.